Personally Guaranteeing the Business's Contracts

April 13, 2006

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In practice, personally guaranteeing the business's contracts will be a contract exception to limited liability that the small business owner will not be able to avoid in some cases.

Simply put, creditors often will insist that the owner of a small business personally guarantee the entity's contract because the creditor is unwilling to rely on the credit of the entity itself (usually for good reason, either because the entity has been structured properly for asset protection, or because the business is not successfully generating any wealth). It would be unheard of, for example, for a commercial lender, such as a bank, to make a loan to a small limited liability company (LLC) or corporation without insisting on a personal guarantee.

With a personal guarantee, the owner will sign the contract twice, once in a representational capacity for the business and again in a personal capacity (see our case study on properly signing contracts.

While commercial lenders and many other providers of credit will commonly request a personal guarantee, it is also true that many creditors will not make such a request. For example, in practice, it is common for some suppliers to request a personal guarantee, while others providing the same materials and quantities will not make such a request.

Here is one rule for the small business owner to follow: If they don't ask for a personal guarantee, don't volunteer it. Of course, care must also be taken in executing the contract to ensure that the party to the contract is the entity, and that the owner signs properly only as an agent of the entity.

In many cases, a pre-printed form contract from a supplier will already have a guarantee clause in it. Business owners will find that, in this situation, they can sometimes sign only as an agent of the business entity, and leave the signature line for the guarantee clause blank, without objection from the supplier.

Other times, the clause will be absent, or the supplier will allow the small business owner to open an account informally with a pre-printed form that merely serves as a collection vehicle for information about the business. This form is not actually a contract and usually will not contain a personal guarantee clause.

Clearly where no form is used at all, there is no personal guarantee. Here, it is especially important, however, to make sure the account is opened only in the name of the entity, all invoices are billed solely in the name of the entity, and that the invoices are paid with checks that, at the top, contain only the name of the entity.

In summary, even this exception to limited liability can be avoided in many cases.

Work Smart

The personal guarantee exception to limited liability for contracts can be used to illustrate another rule in asset protection planning--it's a two-way street.

The strategies that the small business owner employs when he is the debtor should be considered, in an opposite way, when he is a creditor. For example, the small business owner will always try to avoid providing a personal guarantee when he is the debtor, but he should always insist on a personal guarantee when he is the creditor.

Finally, despite having a business entity such as an LLC or a corporation, some small business owners mistakenly sign contracts in their name only. This is the most egregious example of failing to sign a contract properly and inadvertently personally guaranteeing a contract. Fortunately, it is also the easiest mistake to avoid.